"Upstream companies, did, in fact, plan to spend at 2004 levels or greater, many were taking higher risk shots, and all emphasized running their businesses for the long term," Merrill said in a note to clients.

"Overall, we viewed the tone as being both realistic and bullish. We liked the fact that the services and drillers...addressed production capacity needs, and not commodity pricing. In the past, when those managers became oil economists, the stocks went south."

Price volatility has taught the industry some tough lessons.

Spot oil prices plunged from $25.92 a barrel in 1996 to $12.08 in late 1998. The following year, oil roared back to $25.60, inched up to $26.80 in 2000 and then fell to $19.84 in 2001.

Natural gas is even more volatile, soaring briefly to $9.78 per thousand cubic feet in 2000 before falling to $2.57 in 2001.

"Again, we're seeing remarkable restraint in capital investment in the upstream (exploration and development)," said Art Smith, chairman of the research firm John S. Herold. "The concern is about prices collapsing."

Indeed, analysts polled by Thomson First Call predict oil and natural gas prices far below where they are currently trading on the New York Mercantile Exchange. On Monday, crude futures were fetching about $49 a barrel and natural gas was at about $7.80.

In 2005, analysts expect a West Texas Intermediate crude price of $35.99 a barrel, down from $38.91 in 2004. For natural gas, analysts expect prices to moderate to $5.65 per mcf in 2005 vs. $5.82 in 2004.

"You've got to be real cautious," said John Felmy, chief economist at the American Petroleum Institute, a Washington trade group that represents about 400 oil and gas companies. "Once you invest billions of dollars, shareholders want to see the return."

Exxon Mobil Corp.
XOM, +0.92%
always maintains that it sets capital spending based on economic viability and not on the price of commodities. See related story.

Independent producers "tend to be more price reactive in terms of capital spending, but even then, the largest independents are finding...that investors only pay for sustainable growth," said Bruce Schwartz, credit analyst at Standard & Poor's.

"Nobody is modeling on $50 oil. Companies can hedge, but investors get mad when the hedges are out of the money. (The companies) are left with a dilemma."

In looking toward sustainable growth, companies are focused on developing areas with greater potential and higher risk such as West Africa, the Caspian region, and deepwater fields in the Gulf of Mexico, a move away from the shallow waters of the U.S. Gulf, where decades of drilling have depleted resources, Schwartz said.

"In the U.S. Gulf, the breakeven costs have risen dramatically," he said. "For most projects, the sustained natural gas price has to be at least $4, if not close to $5, to be economic. There were prospects that were economic at $3 gas, but that inventory is just gone. The projects (now) require a lot of confidence in the gas price."

The aggregate natural gas production of BP
BP, +0.53%,
Chevron Texaco
CVX, +0.07%
and Exxon has declined about 14 percent from 2001 to 2003, Schwartz said. That figure does include divestitures of properties.

In a presentation at the Merrill Lynch conference this week, Exxon President Rex Tillerson noted that the International Energy Agency in 2003 estimated it would take $200 billion a year in new oil-equivalent production investment to meet expected demand.

"Meeting this challenge will be a considerable undertaking for the industry," he said. "It assumes that governments are willing to provide access to resources with sufficient fiscal certainty to encourage investment by the industry. The projects involved are capital intensive, are often in remote areas and in difficult physical environments."

Exxon had $20 billion of cash at the end of the third quarter. Tillerson told the audience he gets a lot of questions about why the company isn't spending more money on capital projects. In 2003 alone, the company started 16 major projects.

"People recognize that we deliver good profitable projects, so they want to know why not more?" he said. "The short answer is - we are investing more. Believe it or not, price does not accelerate project implementation nor does it tend to advance the pace of new projects."

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